Tuesday, November 29, 2011

The education bubble…perhaps we need less investment!

As a recent MBA graduate and re-entrant to the workforce with a higher education, I could not help but question the value of higher education in the United States. What feared me the most is the uncanny similarities I found with the Mortgage Bubble. Both have asymmetry of risk tangled with government policy detaching it from free market forces, and a society with psychologically deep rooted beliefs on the merits of its value.

Here’s a brief history of the student loan market that highlights the never ending cycle of ever increasing tuitions.

As banks withdrew from the student loan market, the Department of Education (ED) became the direct lender to students. Because the ED can borrow at low Treasury Bill rates, student loans at 7.9% interest rates became a hugely profitable business for the government - especially when the ED does not bear the risk of delinquencies.

As a result, maximum loan amount available to students continues to soar. As students can borrow more each year, schools have been raising tuition keeping up with the increase in loaned funds. In fact, according to ED statistic, college tuition increased from 6% of average household income in 1990 to 17% in 2010 – almost tripling!

The effect of combining a government who profits from lending to students, colleges who benefit from raising tuitions and students who believe higher education is worth any price, is the creation of a reinforcing cycle of ever increasing student debt.

However, this cycle is detached from the reality of demand and supply. The flood of highly educated work force has increased the price of entry to the corporate worldwell, price is a misnomer since corporations are demanding graduate diplomas for jobs that can be performed by interns, yet the global competitive forces bar corporations from paying salaries commensurate with a rate of return on the education investment. And hence, we have created an environment of defaults and delinquencies. According to another statistic only 37% of the 2005 borrowers have made timely payments.

As with the mortgage bubble, the lending risk is absorbed by a third party other than the lender. In case of mortgages, it was the holders of the asset-backed-securities and for education loans it is ultimately the taxpayer – as government is the lender. This asymmetry of risk creates a moral hazard. The ED only reaps the benefits of the higher profits from ever increasing loans without the need to look at the risks of lending. Sounds familiar?

That moral hazard created easy money for the housing industry and thus sellers could sell a house at a price based on how much a borrower can borrow – completely detached from the fundamentals of the borrowers’ ability to pay based on his/her earnings. It is the identical pattern in the education industry where tuitions are increasing according to the availability of funds detached from the earnings potential that education investment will generate.

And of course all this is possible by creating a culture that values the asset beyond rational limits. The idea of the American Dream made the average American value its investment in the house more than the reality of market forces. After all, the Germans and the French rent their homes. The same cultural belief in the value of higher education has made the American public ignore the forces of demand and supply and the market equilibrium price of education - whereas global forces have kept the earning potential in check and return on education investment in the negative.

However, when the education bubble bursts, the taxpayer will absorb all of the costs, unlike the mortgage crisis where some of the loss was absorbed by shareholders. And given that education loans, at $830 billion, have surpassed credit balances at $825 billion, we have more than the overpricing of education to worry about.

It’s perhaps that we do not need more investment in education to exacerbate this bubble further, but less. To compete in the global field, perhaps we need to set the price of education working backwards from the potential earnings it can generate in this global world. Perhaps the woes of the American downfall is not that we score poorly in math, but that we pay too much to score poorly in math. After all, how many scientists do you know who work as business analysts rather than working on that next invention. Do we really need more scientists then?


  1. genius. thank you for this insight.

  2. You've made some great points! The mere fact that people feel compelled to go back and get a higher education just to have a liveable wage says more about the American economy than education system.

    Pretty soon we'll be like Russia or Israel who had PHD's sweeping the streets and driving taxis. If there is no market for the product, it's hard to justify the product no matter how valuable it it is.

    Furthermore, we've dummied down education to the point of absurdity. Kids come out of High School and if they play it right, can have an associates or bachelors through con-current enrollment programs.

    Once kids pass a standarized test of GMAT, LSAT, (usually after intense prep courses) they are in a Grad-School that feels compelled to push them along once admitted. All this leads to really unqualified canidates with a great degree. There is a trust defecit by employers and companies that have seen to many "prestigious" diplomas equal bad employees.

  3. Great points! But we do need more scientists and engineers for key industries in the US. Tech companies here in Silicon Valley regularly relocate employees from abroad since they can't get enough local candidates. (PhDs sweeping the streets will probably be limited to the non-technical ones, or foreign countries like Russia.)

    So to grow our economy we should encourage technical education, perhaps by regulating tuition to make it less costly than non-technical degrees. The same goes for other industries with worker shortages (e.g. nurses).

  4. @Anonymous directly above: Sounds like you're talking about price controls, which notoriously result in shortages... The disconnect between the lending and the risk (as explained in the article) is bad because it distorts the market. Arbitrarily regulating prices likewise distorts the market, and would likewise carry negative results.